Event

A Canadian observer’s view of the North American air transport industry

Presentation by Pierre Jeanniot, former president and CEO of Air Canada, director general emeritus of IATA and MEI Senior Fellow, as part of the Global Air Transport Outlook Conference held in Montreal on June 30, 2006, by the International Civil Aviation Organization (ICAO) and Airports Council International (ACI).

Ladies and gentlemen,

In my opening remarks yesterday morning I noted that, in Canada, a new industry equilibrium appears to be in the making.

Air Canada reported net income of $ 258 million for 2005 – just a year after the airline’s restructuring – and net income of $118 million in the seasonally slow first quarter of 2006.

WestJet also posted strong profits both last year and in the first quarter, as did CanJet and Air Transat in its recent second quarter.

I used the word “new” in the sense that the Canadian industry has regained the stability it once enjoyed. First before deregulation, through government policy, but also subsequently when the two main opponents at the time, Air Canada and Canadian, had achieved a mature acceptance that competing on product value to grow the market was a better way to profitability than competing on price alone for market share.

Following the present prolonged period of great instability, Air Canada has managed to retain its role as the national carrier serving all major international destinations, and with a strong presence across North America.

West Jet, the main domestic competitor, enjoys some 30% of the lucrative Canadian transcontinental market and sees niche opportunities for itself on the trans-border. However, its rapid growth has come at the expense of a major increase in long term debt – now totalling some 1.1 billion USD – which is some two and a half times its equity.

With the return on capital having plummeted from as high as 18.4 percent some six years ago to less than four percent for the past two years, West Jet’s expansion is likely to be more moderate from now on.

By way of comparison, Southwest Airline – the role model of all those so-called low cost airlines – has consistently averaged 11 percent year after year.

CanJet seems content with operating short-haul destinations out of its Halifax base, supplemented by “sun” destinations in the winter.

Air Transat is well entrenched as Canada’s premier integrated leisure airline and tour package operator.

All those carriers have seemingly decided to avoid disastrous price wars and are a great deal more focussed on achieving a good bottom line.

I’m sure our American friends would love to hear the U.S. industry is also stabilizing. Unfortunately there the litany of difficulties continues unabated:

  • Despite heavy traffic and higher fares, American again lost money in the first quarter.
  • Continental narrowed its loss but the forecast for 2006 is dim.
  • United emerged from three years of bankruptcy protection in February and lost 306 million USD in the first quarter of this year, which is slightly more than it did in the first quarter of 2005.
  • Northwest’s bankruptcy reorganization added a billion dollars to its first quarter loss.
  • Delta is still struggling to emerge from bankruptcy protection, and last month had to silence its Song low-cost subsidiary.
  • Southwest still made money but had to fight harder to maintain its edge.

What’s wrong with the U.S. industry?

Why are the U.S. legacy carriers seemingly unable to restructure successfully and achieve the kind of positive developments occurring in Europe and elsewhere?

To add – and perhaps reinforce – some of the opinions and views already expressed at this Conference, let me point to a very important difference between legacy carriers in the U.S. and those of Europe and elsewhere.

As much as 70 to 75 percent of the traffic carried by the major U.S. airlines is domestic, and only 25 to 30 percent is international.

The reverse is true for European carriers.

As U.S. low-cost carriers concentrated almost exclusively on domestic markets, the American legacy airlines were that much more vulnerable than their European counterparts.

Their attempt to achieve parity with the low-costs required far more extensive restructuring.

There were just too many overhead and fixed costs to reduce.

Legacy carriers also carry the legacy – of huge pension funds with an unmanageable unfunded gap, as well as other burdens that come with being around for a long time –. as some of us grey heads here today know all too well.

The financial difficulties of legacy carriers over an extended period of time have forced them to put fleet renewal on the back burner.

Too large a percentage of their fleet consists of 25 year-old plus aircraft.

Their fuel and maintenance costs are much higher than those of, say Jet Blue, which flies the new, 20 percent more fuel-efficient Airbus 320s and Embraer 190s.

Jet Blue was a good example of how, generally, the low costs have been able to enter domestic markets and prevail almost overnight because of a new, efficient fleet and low overhead, low-seniority employees, lean headquarters staff in airport hangars, no-frill service, etc.

But when I say that Jet Blue was a good example, it is because Jet Blue has since broken away from the low cost formula by acquiring a second aircraft type and introducing an upgraded hybrid service.

And we all know that a mixed fleet is a “no-no” for any low-cost.

The airline has now posted its second quarterly loss, and it remains to be seen whether this change in strategy will succeed – or may in fact turn out to be a costly mistake.

It will be interesting to watch whether the U.S. Airways-America West merger will truly turn out to be successful.

U.S. Airways earned $65 million in the first quarter, in part because the merger with America West allowed it more leeway to trim less lucrative routes and beef up more profitable pairings.

Despite their good efforts, I don’t think that the legacy carriers are yet off the hook in their need to downsize and consolidate into lean – and mean – competitors.

Unfortunately in my view, Chapter 11 is preventing the required consolidation of the legacy carriers.

When Pan Am and Eastern were allowed to disintegrate other airlines picked up the pieces worth saving, such as part of their fleets, gates at congested airports, and a number of international route rights.

I said yesterday that the European experience is proving that consolidation and mergers can produce positive results.

I believe that U.S. legacy carriers, reborn into three or four strong competitors, would also benefit from cross-border mergers with alliance partners – something which is currently prevented by a U.S. aviation policy that puts very restrictive limits on foreign investments.

The Canadian industry has given signs of being interested in such a development.

As a case in point, Air Canada’s minority investment in Continental some years ago was a precedent that proved profitable for both carriers.

With a population of only 33 million, the conundrum for Canada’s airlines is where to grow.

The skies opened a little wider with the Canada-U.S. agreement signed last November.

The 5th freedom rights negotiated provide an opportunity for Canada to link U.S. and European markets through Canadian points.

The U.K.-Canada bilateral, recently agreed in principle, offers similar opportunities if it can ensure that the 5th freedom ultimately defined would match those in the U.S.-Canada bilateral, and thus permit Canada’s airlines to participate in U.K. to U.S. markets through Canadian hubs.

Given U.S. concerns about security, foreign ownership and cabotage, I don’t think further liberalization of the Canada-U.S. agreement will happen any time soon – just as, for the same reason, the EC-U.S. negotiations are at an impasse.

As a temporary alternative to a fully integrated common air market over the Atlantic between Europe and North America, the European Commission could perhaps be interested in a discussion with Canada along the lines of their proposal to the Americans.

With cabotage no longer of great importance to the E.C. position, other concerns – even security – could be overcome.

Canada has stated on several occasions that on a reciprocal basis, foreign ownership of Canadian carriers could readily be increased to 49%.

The advantages to both Europe and Canada are obvious.

Some 25 bilaterals would be replaced by one agreement covering the whole European Common Market.

Canada’s airlines would have “open skies” access to a market of some 450 million people – some fifteen times its own population.

The European Community would achieve the successful implementation of their common Atlantic air market approach, with a major North American partner.

The experience learned in such an agreement would be useful to all parties in eventually overcoming U.S. reluctance.

A Canada-E.C. agreement would be another step in modernizing the Chicago convention and moving beyond the archaic air bilateral approach which may have served the industry well in the past, but is now of another age.

As Canada and other countries have learned, the market knows better than governments as to who should fly where, how often, and at what price.

Our global village may still be a long way from one common air market, but despite hesitation and reluctance by many – and outright refusal by some – it is moving steadily towards this eventuality.

At stake are continuing world economic growth, satisfying universal consumer demand, and the overwhelming need to rationalize the international air transport industry to achieve, finally, a sound financial basis.

Transportation – perhaps as much as agriculture – was essential to the start of civilization, and has been an integral part of our economic and cultural growth ever since.

Canada knows that well.

More than many other nations, Canada was created and developed with the help of transportation.

The growing importance of international trade to Canada requires the continued support of an enlightened transportation policy.

Canada’s need to remain at the forefront of the liberalization process is not uniquely altruistic, but I believe that increased market access would ultimately benefit everyone.

We all know that a “big bang” solution to worldwide liberalization is most unlikely, and that we are likely to continue in a step-by-step approach.

The way to proceed appears to be, therefore:

  • Continued expansion of bilateral “open skies” agreements by all like-minded nations;
  • Continued expansion of regional common air markets such as achieved by the European Community; and
  • Pursuit of bilateral agreements between regional common air market areas and other regional areas – or by “block-lateralism,” to use an expression coined some time ago.

Globalisation of industry, trade and commerce is a process which has been unfolding for many years, and of course the World Trade Organisation (W.T.O.) has been working hard at removing trade barriers on many fronts.

But international aviation, together with the communication networks, should be credited with having largely contributed to the acceleration of globalization we have been witnessing.

Now, it is a rather curious paradox that the airlines themselves would remain unable to become truly global entities themselves.

Why is it that the automotive industry, the pharmaceutical industry, or the petroleum industry – and so many other industries – are given full freedom of action on a worldwide basis but the airlines are not?

The restructuring of the airline industry in North America remains unfinished.

Low costs now represent 42% of the U.S. domestic market and their share will probably level off at 50%.

Now six legacy carriers vying for the remaining 50% may prove to be too many to ensure a stable, profitable industry.

Would it not be desirable to encourage consolidation into three or four major national carriers once again able to hold their own domestically, and internationally?

Some have suggested that Chapter 11 bankruptcy protection should be modified to limit the frequent resuscitation of moribund airlines – which may only serve to prolong the agony.

And we must also encourage more mergers and consolidations internationally. I do not wish to discourage membership in IATA, but wouldn’t the industry and the travelling public be better off if, instead of 250 marginal national carriers, the international airline industry was to consolidate into maybe 30 or 40 strong global competitors?

Should consolidation accelerate internationally, would the U.S.A. be content to watch it from the sidelines and prevent opportunities for its reborn U.S. legacy carriers to merge with international alliance partners – which would require that the U.S. aviation policy become less restrictive about foreign ownership?

Surely questions of security and ownership can be addressed satisfactorily if the will to do so is there.

The process of dismantling the barriers preventing world deregulation of international aviation must be vigorously pursued.

In this quest, it is hard to believe that the U.S.A. would not choose to remain a key driver.

The prize is surely worthwhile. At stake is the emerging of an industry finally allowed to behave like most others – stable and profitable.

Pierre Jeanniot is the Former President and CEO of Air Canada, Director General Emeritus of the International Air Transport Association (IATA), and Senior Fellow at the Montreal Economic Institute.

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